How should a company set the pay of its chief executive?
Bengt Holmstrom, an economist at the Massachusetts Institute of Technology, has won the Nobel Prize for Economics along with Oliver Hart, who can be found at nearby Harvard, in part for his work on that very subject.
Mr Holmstrom, who is a former director of Nokia among other things, in the 1970s demonstrated how a principle, for example, a company’s shareholders, should design an optimal contract for an agent, say, their chief executive.
His “informativeness principle” is a model for how the CEO’s contract should link their pay to information relevant to their performance, after due regard has been paid to weighing risks against incentives. The work has been developed, debated and refined since that time.
In the US, where the two men work, that debate is currently centred upon on the eye popping awards handed to executives at Well Fargo, a retail bank in the midst of a scandal over the creation of bogus accounts.
John Stumpf, its chief executive officer, is to forfeit $41m (£33m) in unvested share awards, will not receive a salary while the bank investigates the scandal, and won’t receive a bonus for 2016.
Carrie Tolstedt, who headed the community banking unit that employed numerous workers who illegally opened unwanted accounts, has lost unvested share equity awards worth about $19 million. She also won’t receive any severance pay, or any bonus for 2016 and won’t be able to sell any stock during the probe.
It sounds painful, but they’ve both made considerable fortunes through working at the bank and as the writs fly, and the bank’s shares slide, the shareholders who hired them have lost considerable fortunes.
Needless to say, the creation of new accounts was heavily incentivised, while staff were pressurised to meet unattainable targets. Clearly the risk - that people in this environment would end up gaming the system - wasn’t effectively weighed when the incentives and the targets were set.
More fool shareholders for approving the awards in the first place, you might think. Perhaps they ought to read up on Mr Holmstrom’s work.
But the problem goes beyond the methods used to set pay and design packages.
The CEO pay pot had already been stirred by corporate governance research firm MSCI, which examined the packages of some 800 CEOs at 429 large and midsize US companies during the 10 years to the end of 2014. It also looked at the total shareholder return of those companies - a measure of the share price performance and of the dividends paid.
The firm found that had you invested $100 in the one fifth of those companies with the highest paid CEOs you’d have made $265. However, if you had put your money with the companies that paid the least you’d have made $367.
This challenges the prevailing assumption that shareholders do better when they make a hireling an owner alongside them and incentivise them by handing them chunky share awards tied to company performance.
What all the toing and froing, including Mr Holmstrom’s prize winning model, misses is a rather important point: There are social consequences to executive rewards as well as corporate and investment consequences.
Companies do not exist in vacuums. At a time of rising inequality, and insecurity, the pay packages handed to their CEOs are contributing to the anger and unrest that are the consequences.
It isn’t exaggerating to say that they played a role in both the disastrous Brexit vote and the rise of Donald Trump, a plutocrat promising to tear up the system up in favour of the ordinary working Joe. Scarcely credible, I know, but people are buying it even after the ugly revelations about his sexual behaviour that emerged over the weekend.
Both phenomena have their roots in populist outrage at an economic system that appears rigged.
As such, it isn’t only model for setting CEO pay, and how it is linked to performance, that is at fault. The problem is not with agents, and principles, and the finer points of contract theory that the prize winners cast light upon.
It is as much with the quantum of awards that have surged at a rate that far outstrips the growth in average earnings, where there has been any growth at all, and the effect that has had against the backdrop of an increasingly insecure and unequal society.
Biggest business scandals in pictures
Biggest business scandals in pictures
1/18 Former Reckitt Benckiser executive linked to death of 100 people in South Korea jailed for seven years - Friday January 6
A former South Korean executive of UK-based Reckitt Benckiser has been jailed for seven years over the sale of a humidifier disinfectant that killed about 100 people and left hundreds with permanent lung damage. Shin Hyun-woo, head of Reckitt Benkiser’s Oxy subsidiary from 1991 to 2005, was found guilty of accidental homicide and falsely advertising the deadly product as being safe even for children. The consumer product disaster affected many families in South Korea, where children and pregnant women often battle dry winter seasons with humidifiers. Other retailers such as Lotte Mart and Homeplus were also found guilty of selling the deadly product.
2/18 Rogue trader
A French court cut the damages owed by rogue trader Jerome Kerviel from €4.9bn (£4.2bn) to just €1m (£860,000). The court ruled on that Kerviel was “partly responsible” for massive losses suffered in 2008 by his former employer Societe Generale through his reckless trades. Kerviel has consistently maintained that bosses at the French bank knew what he was doing all along.
3/18 Lloyds chief apologises for damage caused by affair allegations - August 2016
Antonio Horta-Osorio, the chief executive of Lloyds Bank, has broken his silence over allegations about his private life admitting he regrets any "damage done to the group's reputation". In a message sent to the bank's 75,000 employees, the banker said that anyone can make mistakes while insisting that staff had to maintain the highest professional standards.
4/18 Christine Lagarde faces court over £340m Bernard Tapie payment - July 2016
The head of the International Monetary Fund (IMF), Christine Lagarde, must stand trial in France over a payment of €403 million (now £340m, then £290m) to tycoon Bernard Tapie, a France's highest appeals court has ruled. The court rejected Ms Lagarde's appeal against a judge's order in December for her to stand trial over allegations of negligence in her handling of the affair. Ms Lagarde could risk a maximum penalty of one year in prison and a fine of €15,000 euros if convicted.
5/18 HSBC senior manager arrested in FX rigging investigation at JFK airport in New York - July 2016
A senior executive at HSBC has been arrested at New York's JFK airport for his alleged involvement in a conspiracy to rig currency benchmarks, according to reports. Mark Johnson, global head of foreign exchange cash trading in London, was reportedly arrested on Tuesday. He will appear before a federal court in Brooklyn on Wednesday charged with conspiracy to commit wire fraud, Bloomberg said.
6/18 Former PwC employees found guilty in 'Luxleaks' tax scandal - June 2016
Two ex- PricewaterhouseCoopers staffers were found guilty in Luxembourg of stealing confidential tax files that helped unleash a global scandal over generous fiscal deals for hundreds of international companies. Antoine Deltour and Raphael Halet face suspended sentences of 12 months and 9 months and were ordered to pay fines of €1,500 (£1,230) and €1,000 (£822) for their role in the so-called LuxLeaks scandal. Despite the minimal sentences, the ruling was described by Deltour’s lawyer as “shocking” and “a terrible anomaly.” The ruling “puts on guard future whistle-blowers,” Deltour told reporters.The LuxLeaks revelations sped beyond Luxembourg, causing European Union regulators to expand a tax-subsidy probe and propose new laws to fight corporate tax dodging, while EU lawmakers created a special committee to probe fiscal deals across the 28-nation bloc.
7/18 Goldman Sachs dealmakers lavished Libyan officials with prostitutes to win contract - June 2016
A former Goldman Sachs dealmaker trying to persuade Gadaffi-era Libya to invest $1 billion with the investment bank procured prostitutes and invited Libyan officials to lavish parties in the hope of winning the business, the High Court heard on Monday June 13.The Libyan Investment Authority sovereign wealth fund is suing Goldman Sachs for inappropriately coercing its naïve staff into giving its sovereign wealth fund cash to the bank to invest in products they did not understand. The products were designed to generate big profits for Goldman, the LIA claims.Goldman denies wrongdoing and says the LIA was treated as an arms-length customer
8/18 Former boss of BHS said his life was threatened - June 2016
Darren Topp, the former boss of BHS, has said former owner Dominic Chappell threatened to kill him when he challenged him over a £1.5 million transfer out of the business. MPs on the Business, Innovation and Skills Committee asked Mr Topp about a £1.5 million transfer Mr Chappell made from BHS to a company called BHS Sweden.
9/18 Sports Direct founder Mike Ashley admits paying workers below the minimum wage - June 2016
Mike Ashley admitted paying Sports Direct employees below the minimum wage at a hearing in front of MPs. The company founder said that workers were paid less than the statutory minimum because of bottlenecks at security in an admission that could result in sanctions from HMRC.
10/18 Mitsubishi admits ‘improper’ fuel tests - April 2016
Mitsubishi has admitted to using false fuel methods dating back to 1991. The scale of the scandal is only just coming to light after it was revealed in April that data was falsified in the testing of four types of cars, including two Nissan cars.
11/18 Panama Papers: Millions of leaked documents expose how world’s rich and powerful hid money - April 2016
Millions of confidential documents have been leaked from one of the world’s most secretive law firms, exposing how the rich and powerful have hidden their money. Dictators and other heads of state have been accused of laundering money, avoiding sanctions and evading tax, according to the unprecedented cache of papers that show the inner workings of the law firm Mossack Fonseca, which is based in Panama.
12/18 Google's tax avoidance
Google reached a deal with the HM Revenue and Customs to pay back £130 million in so-called “back-taxes” that have been due since 2005. George Osborne championed the deal as a “major success”. But European MEPs have since called for the Chancellor to appear in front of the committee on tax rulings to explain the tax deal.
13/18 Turing Pharmaceuticals and Martin Shkreli
Martin Shkreli became known as the “most hated man in the world” after his drug company, Turing, increased the price of a 62-year-old drug that treated HIV patients by 5,000% to $750 a pill. He was charged with illegally taking stock from Retrophin, a biotechnology firm he started in 2011, and using it pay off debts from unrelated business dealings. Shkreli, who maintains he is innocent, and says there is little evidence of fraud because his investors didn't lose money.
14/18 Volkswagen emissions scandal
VW admitted to rigging its US emission tests so that diesel-powered cars would looks like they were emitting less nitrous oxide, which can damage the ozone layer and contribute to respiratory diseases. Around 11 million cars worldwide were affected.
15/18 Quindell, the scandal-ridden insurance firm
Quindell was once a darling of AIM but its share price fell in April 2014 when its accounting practices were attacked in a stinging research note by US short seller Gotham City. In August the group was forced to disclose that the £107 million pre-tax profit it had reported for 2013 was incorrect, and it had in fact suffered a £64million loss.
16/18 Toshiba Accounting Scandal
The boss of Toshiba, the Japanese technology giant, resigned in disgrace in the wake of one of the country’s biggest ever accounting scandals. His exit came two months after the company revealed that it was investigating accounting irregularities. An independent investigatory panel said that Toshiba’s management had inflated its reported profits by up to 152 billion yen (£780m) between 2008 and 2014.
17/18 FIFA Corruption Scandal
Fifa, football's world governing body, has been engulfed by claims of widespread corruption since the summer of 2015, when the US Department of Justice indicted several top executives. It has now claimed the careers of two of the most powerful men in football, Fifa President Sepp Blatter and Uefa President Michel Platini, after they were banned for eight years from all football-related activities by Fifa's ethics committee. A Swiss criminal investigation into the pair is ongoing.
18/18 Libor fraudster
City trader Tom Hayes, 35, has become the first person to be convicted of rigging Libor rates following a trial at London's Southwark Crown Court. Hayes worked as a trader in yen derivatives at UBS before joining the American bank Citigroup in Tokyo. He was fired from Citigroup following an investigation into his trading methods. He returned to the UK in December 2012 and was arrested following a two-and-a-half year criminal investigation by the SFO.
The winners of the Nobel Prize for Economics are to be congratulated. They are clever, talented people who have done valuable work. For that they will split SK8m (£745,000).
It is a tidy sum but it just serves to illustrate the point I just made. The average FTSE 100 chief executive will make that sum in less than three months. Their US equivalents will make it after an even shorter interval. For far too many that sum would represent a mere rounding error when set against their overall package including, I’m sorry to say, the bosses of Wells Fargo.
What we really need to discuss is not the methods or the models used to set executive pay, but how best to bring it down to a more acceptable level given the unrest it is contributing to.
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